This paper examines how trade liberalization affects the innovation incentives of firms, and what this implies for industry productivity. For this purpose we develop a reciprocal dumping model of international trade with heterogeneous firms and endogenous R&D. Among the robust results that hold both in the short run when there is no entry, and in the long run under free entry are that trade liberalization increases (decreases) aggregate R&D for low (high) trade costs and increases expected industry productivity. The central results of the paper regarding firm and industry level R&D spending differ significantly from the case of homogeneous firms.